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Reprogramming European cable: European cable companies are in dire financial straits. The reason? Not just debt but a strategy that has produced negative cash flows across the whole industry.

Europe's cable operators are undoubtedly suffering. After borrowing heavily in the mid-1990s to roll up small players and to upgrade digital systems intended to help them sell bundled services, they now find themselves counting losses rather than the profits they expected. The industry's "triple-play" bet--that customers would jump at the convenience of buying television, Internet, and telephony services from a single provider--hasn't yet paid off, for consumers have failed to summon enough interest to make it succeed.

Not surprisingly, attention has focused on the operators' enormous debts. NTL, a US company that is Europe's fourth-largest operator, declared bankruptcy in May 2002, exchanging $10.6 billion of debt for equity and wiping out its equity holders. United Pan-Europe Communications (UPC), Europe's third-largest operator, defaulted on its bond payments and was delisted from Euronext (the combined stock exchange of Belgium, France, and the Netherlands) when its debt exceeded its shareholder equity Ish, a German cable operator, has filed for Chapter 11. These are just a few of the many companies across Europe that are struggling. But merely restructuring this debt won't get them out of their predicament. The problem is strategy.

To survive, companies must create new business models for themselves quickly Under current conditions, many of them should consider dropping the monopoly-operator system (common in Europe and the United States), which excludes other service providers from their networks, and follow the lead of mobile-telecom operators and ISPs by sharing networks. Sharing, these companies have found, increases the size of the total market, lowers the costs of the operators, improves their use of capital, and spreads risk. It could do the same for cable operators.

During the dot-com boom, European cable companies were far from alone in believing that consumers would quickly adopt digital services and welcome the convenience of the triple play. But this wasn't their only illusion. They also thought that capital spending would decline swiftly once the networks were upgraded and that service and installation costs would remain stable. The result, they supposed, would be rapidly expanding operating margins offsetting the debt incurred both to fund the upgrades and to fuel the consolidation inspired by the pursuit of economies of scale.

Faith in the triple play's potential kept cable operators investing even as capital expenditures and the associated debt for network upgrades, new set-top boxes, IT systems, and digital products (from premium programs and television shopping to interactive games) rose beyond anyone's expectations. Yet a cash flow analysis reveals how little promise the triple-play strategy has in today's market conditions.

Current realities

Cable operators now serve 60 million customers in Europe and generate more than [euro]10 billion ($9.84 billion) in annual revenues. But most of the major operators have a negative cash flow-a state of affairs that wouldn't end even if all debt and spending on network upgrades were eliminated.

Admittedly, the triple-play approach does better in some European markets than in others. Each market can be placed in one of four clusters (Exhibit 1), delineated by the extent of the market's cable networks, the level of subscriber penetration, the average revenues per customer, (1) and the competitive and regulatory environment. But no matter where cable companies operate, the triple-play strategy they have pursued is unsustainable. With two of the clusters as examples, Exhibit 2 (on the next spread) shows how this business model currently fails on a cash basis: the cost to companies of maintaining their current triple-play customers and of acquiring new ones exceeds the revenue from existing customers. In other words, every marginal customer is unprofitable.

The problem is that the market hasn't developed as expected. On the revenue side, the triple play requires average monthly receipts of [euro]30 to [euro]100 per customer (depending on the cluster) to be profitable, but so far companies have earned only [euro]9 to [euro]15 across most of Europe; the highest figure, in the United Kingdom, is only [euro]60. While some companies continue to hope for more, recent history suggests that they do so in vain: the take-up rates of broadband, cable telephony, and premium television services such as special sports and movie channels all have been disappointing.

When European companies planned their expansion into digital television, they saw the United States as the only market large enough for comparison. Although US customers might now spend an average of $45 a month on cable, they took 30 years to reach this level, and they spend so much because as few as five free-to-air channels are available to them, while movies and professional sports are increasingly offered solely on premium channels. In Europe, by contrast, government regulation ensures that there is plenty of high-quality free-to-air television--including European football and other highly popular content. European cable operators thus can't offer enough compelling programs to draw viewers to their channels. Moreover, strict pricing regulation in Europe limits the cable operators' ability to develop tiered pricing models (for instance, targeted programming packages) that might drive revenue growth.

In the days when broadband and other digital services were to be the engines of that growth, television seemed less important. But the adoption of broadband has lagged far behind the levels projected during the dot-com boom. Meanwhile, except in the United Kingdom, consumers see no great reason to change suppliers and have shown little interest in cable telephony. Cable operators will thus find it hard to make either market grow. Furthermore, the operators face strong competition from entrenched telephone companies selling their own version of broadband-DSL--which has the lead in Europe and is poised to become the standard for home use, much as cable is winning in the United States. In telephony, those same telephone companies have the scale to defend their markets vigorously.

On the cost side, expenditures are still too high, though many cable operators are trying to reduce them by renegotiating the price of set-top boxes and by expanding more slowly. (Setting up a new customer with digital services costs, on average, at least twice as much as an analog installation, for example.) A further problem is that digital interactive products suffer five to ten times as many faults as analog ones, so that repair costs are higher, and it is necessary to have more intricate--and expensive--operational capabilities and network monitoring.

The call-center costs of the cable operators have increased because they must respond to the more complicated queries that arise from bundling several complex products. Finally, the sales and marketing expenses of these companies, which hitherto had little need of such expertise, have gone up; in Belgium, Germany, and Switzerland, for example, the cable operators have had no direct relationship with the customer, because cable service is often included in apartment rent, so they now desperately need to educate a public that is reluctant to purchase their services.

Light at the end of the tunnel

European cable companies are thus troubled by a vicious cycle of negative cash flow and continually rising debt. The industry is far from stable, and operators will have to reassess their strategies constantly (see sidebar, "An uncertain future"). And whatever the future holds, cable companies must make big changes if they wish to be a part of it.

Some might choose not to abandon the triple-play strategy, but in that case they will have to restructure their debt and carry out a complete operational overhaul. The required reforms are not, on their own, new or impossibly difficult. They include a reduction in capital expenditures, the improvement of marketing and operational efficiency, efforts to ensure that operations and management support the triple play, and the development of performance metrics that reward these new goals rather than focusing, in the industry's traditional manner, on financial deal making. Since these reforms must all be implemented simultaneously, however, they represent a formidable challenge. Many companies will fail to make them or won't make them quickly enough to avoid near-term bankruptcy.

What else could cable operators do? Besides restructuring their debt, some of them feel that the solution to their problems is to delay further investments until the economics are clearer--although this strategy opens up the possibility of losing the market to competitors, including satellite-television operators and telecom companies offering DSL and various telephony packages. Other cable companies will be tempted to try to boost their revenues by either developing or aggregating content such as television programming or broadband-specific applications. The problem here is the expense and the fact that cable operators generally lack the necessary skills.

There is also a third option: a "multiple-access" strategy. In this case, a cable operator allows other companies to offer one or more elements of the triple play (or additional services such as music or gaming) over its network. Cable operators, given their monopolistic history, might dislike the idea of multiple access, but economic pressures should bring some of them around. The strategy's virtue is that it addresses both the revenue and the cost sides of the negative cash flow problem and is workable anyplace where networks have been completely upgraded or where customers are attractive enough demographically to make continuing upgrades worthwhile. Networks in most of the United Kingdom, the Benelux countries, Switzerland, and parts of France lend themselves to multiple access.

Since the networks of most companies haven't been completely upgraded, many would want to combine multiple access in upgraded areas with a pure cost-cutting strategy in nonupgraded ones. In the latter (parts of France and large swaths of Germany), companies can stabilize their finances until conditions improve by offering only relatively low-margin and low-growth analog television, without premium channels, broadband, or telephony.

Cable radicals

The results of companies in other industries show how successful a multiple-access strategy can be. In the United Kingdom, for example, the smallest mobile-network operator--one 2 one, recently renamed T-Mobile--made an agreement with Virgin, a retail conglomerate with strong brand and marketing expertise, to offer telephone service over one 2 one's network. The result was a 10 percent boost in the compound annual growth rate of subscribership across it.

Another example of such strategies was the relationship between Energis, a UK-based telecom network owner that sells its own services, mainly to businesses, and Freeserve, a consumer ISP. Energis provided network infrastructure and maintenance for the network that Freeserve's customers used for connections to the Internet, while Freeserve focused on marketing and most customer service. Although financial details are not available, the benefits Energis gained are clear. The company could amortize its network costs over a greater quantity of traffic at a very low marginal cost, and its network, formerly underused in the evenings and on weekends (when Freeserve's traffic is heavy), was paid to carry traffic it otherwise wouldn't have seen, with none of the costs of acquiring new customers or providing them with service.

Cable operators should explore similar arrangements with retailers--especially if they have strong marketing skills or large customer bases; potential partners include media companies, traditional retailers (such as Dixons, the electrical-store chain that initially backed Freeserve), and telecom companies. The advantages could be numerous. New entrants will bring marketing skills that could increase the market's size by increasing the overall penetration of digital-cable services. Average revenue per customer should rise too as partners compete to develop new services--music, perhaps, or games (which are increasingly popular on-line), or a service that combines charges for wireless and cable telephony calls in a single bill.

By adding such services, operators will be able to exploit the expertise they already have and to reduce their reliance on triple-play products. By expanding the use of their networks, they can amortize their costs over a growing quantity of traffic. In addition, these companies can share customer service and setup costs with their partners and might be able to share the risk of upgrades. (Any further capital investments, however, should be aimed at tightly targeted markets.) Finally, the pressure for flawless execution in many business areas will be relieved; network maintenance, for example, might become more complex, but marketing, in which some cable operators are notably deficient, will assume less importance. Multiple-access agreements, while complicated to negotiate, are certainly feasible: under Freeserve's recent deal with NTL, that operator will offer Freeserve-branded broadband access and give Freeserve the right to sell digital television and cable telephony on its network.

The experience of the ISPs suggests that cable companies must provide for two vital elements to make such arrangements work. First, contracts must ensure high-quality network operations and fairness to retailers; the operator will be required to guarantee service quality for all users of its network, particularly when it has a retail presence that competes directly with those of its retail partners. Second, the division of activities between retailers and the network provider must be defined clearly. Network operations and maintenance should be retained by the cable operator, for instance, but each retailer should carry on customer marketing and acquisition separately. Billing, customer service, and the like should be open to negotiation according to each partner's strengths and financial resources; many cable operators already have appropriate facilities, which can be offered to the retail partners in return for extra payments. An additional new challenge for cable operators will be the associated business-t o-business billing and account management.

As for contract terms, wholesale prices must be sufficient to cover the costs of the cable operator but not so high that its partners' economics become unworkable. This point might seem obvious, but some shared-network agreements--including several in the United States between Baby Bell telephone companies and their competitors--have faltered precisely by failing to observe it. The division of retail price increases or of fees related to new services (such as gaming) is likely to require compromise, which will be particularly difficult to reach when a network must be upgraded to offer a new service, for the risk would have to be shared.

As European cable companies adopt the multiple-access strategy, they are going to find that their operating models will change. The cost of maintaining networks and of servicing customers will rise because multiple-access networks are complicated to manage. But this increase should be more than offset by the lower cost of sales and marketing as new partners take on a large share of those activities. Clearly, the scale of the reduction will depend on how far back the cable operator is willing to step: those maintaining a retail presence will have higher costs than pure wholesalers will. But the extra revenue and greater network usage should have a dramatically positive effect on cash flow.

In the dire financial circumstances of the present, Europe's cable companies can't go on as they have. A combination of debt restructuring, big cuts in capital spending, and, for many, network sharing will offer the surest path to survival.
EXHIBIT 1

Mapping the clusters


Intense comptetitors (1)

Average revenue              [euro]27-50
per customer
Penetration                  28-36%
Cable network                36-52%
coverage
Competition, for             High
example, from satellite
or digital TV
Level of government          Low
regulation

New entrants (1)

Average revenue              [euro]14-29
per customer
Penetration                  7-14%
Cable network                5-23%
coverage
Competition, for             Moderate
example, from satellite
or digital TV
Level of government          Low
regulation

Low-revenue competitors (1)

Average revenue              [euro]6-12
per customer
Penetration                  75-84%
Cable network                57-68%
coverage
Competition, for             Moderate
example, from satellite
or digitat TV
Level of government          High
regulation

Traditional monopolies (1)

Average revenue              [euro]8-10
per customer
Penetration                  91-95%
Cable network                94-97%
coverage
Competition, for             Low
example, from satellite
or digital TV
Level of government          High
regulation

(1)Clusters based on operational data for all cable companies in
countries indicated.

Source: Screen Digest European Cable Yearbook, 2001-02; McKinsey
analysis.

EXHIBIT 2

A losing proposition

Cash flow analysis of selected clusters, 2000-01, (1) [euro] per
customer per month

                                         Intense  Traditional
                                     competitors   monopolies

Average revenue per customer                  42           15
Cost of goods sold                            15            2
Maintenance costs                             19           10
Cash before upgrades, acquisitions             8            3
Acquisition costs                             11            8
Costs to upgrade, build new network         5-26         3-11
Cash before financing                  -8 to -29    -8 to -16
Interest payments                             17            8
Cash contribution per customer        -25 to -46   -16 to -24

(1)Based on financial data of 7 European cable companies using most
recently available 12-month data; 4 companies categorized as intense
competitor, 3 as traditional monopolies.

Note: Table made from bar graph


(1.) Average revenue per user is the usual metric, but by convention it measures only the revenue generated by each of the individual services. Because cable companies are trying to sell more than one of them, we use average revenue per customer--which we define as the customer's total spending with the company. By including customers who don't adopt a service with those who do, this metric also reflects the relative success of a cable company in selling its services to its customer base.

RELATED ARTICLE: An uncertain future

Some of the reasons for the instability of Europe's cable industry are predictable: the strong likelihood of more bankruptcies and of new owners such as the US company Liberty Media, which is intent on increasing its European holdings. Other, less predictable developments could favor the cable operators: failures among them might, for example, make regulators act to sustain the industry. In Belgium, they already allow the country's largest cable operator to charge more for incoming telephone calls from other telephone companies than it pays the country's traditional wireline telephone monopoly for routing those calls to it, a decision yielding a large net inflow of revenue.

Another possibility is a reduction (resulting from standardization or greater production expertise) in the cost of the set-top boxes and cable modems that the cable operators use to deliver their services. Cable operators might also benefit if the adoption rate for broadband eventually speeds up, either because it at last reached critical mass among consumers or because a true killer application was devised--unless DSL takes over, in which case the plight of these companies could actually worsen. Finally, their position in premium television could well improve if their satellite competitors were to fail--and outside the United Kingdom, most of the satellite companies are currently struggling.

The authors wish to thank Samir Maha and Chris Pope for their contributions.

Wendy Becker is a principal and Luis Enriquez is an associate principal in McKinsey's London office; Lila Snyder is a consultant in the Stamford office. Copyright [C] 2002 McKinsey & Company. All rights reserved.
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Author:Becker, Wendy M.; Enriquez, Luis; Snyder, Lila J.
Publication:The McKinsey Quarterly
Article Type:Industry Overview
Geographic Code:4E
Date:Dec 22, 2002
Words:3053
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